Should You Follow Insiders Into or Out of These Stocks?

As an investor in a company, it can be hard to take a look at a Form 4, which shows insider buying and selling, and not wonder whether we should follow suit -- especially when shares are being dumped by a company founder, like Clean Energy Fuels CEO Andrew Littlefair, or a top executive like Facebook's Sheryl Sandberg, who's been an important part of the company since the early days. Meanwhile, J.C. Penney CEO Mike Ullman invested $1 million of his personal wealth in shares, and Littlefair actually ended 2013 having bought more shares than he sold. What do all these insiders know that you don't? Should you follow their moves?

Chances are that what they're doing bears no relation to your own investment decisions. Let's talk about why.

Compensation versus investing

Sandberg has sold millions of shares but still holds 12 million more. Source: Wikipedia

It's easy as an investor to see it as a mark against a company when important insiders sell shares. anyone selling one of our investments as a mark against a company. We naturally think, "They know something I don't know." Sheryl Sandberg has sold nearly 6 million shares of Facebook since 2012 -- that's $372 million worth at today's prices. Clean Energy's Littlefair sold 8,000 shares every single month for most of the past two years, netting more than $2 million in the process.

Looking at insider transactions can add valuable information and insight, but looking at the selling with zero context -- or even worse, projecting our situation, and our reasons for holding, onto insiders -- doesn't add value to your process or move you closer to making better investing decisions. One of the main reasons why is that insiders often have a much different relationship with their shares than we do. After all, their holdings tend to be largely a product of compensation, not personal investment. They rarely buy those shares on the market; the shares are a form of currency, paid as part of their employment with the company.

Many reasons to sellThe old saw "many reasons to sell, only one reason to buy" is partly true. Investors in Facebook, for example, buy shares because of the company's massive user base -- more than 1 billion strong -- which offers tremendous monetization from advertising. The most recent quarterly report indicated that the company's efforts in mobile are paying off, with net income up $1.5 billion over last year and revenue up more than 50%, largely due to better results in mobile. Yet Sandberg sold millions of shares while this was happening. As the company's COO, she surely knew profits were growing, right?

But like Clean Energy's Littlefair, Sandberg participates in a trading plan, meaning their sales happen outside of their control, allowing them to sell to generate income beyond their cash compensation, diversify their wealth, or give to charitable causes without any chance that they sold based on insider information. This is all part of receiving stocks as compensation, rather than buying them on the open market.

Only one reason tobuy?

Clean Energy counts UPS as a customer, but fewer than anticipated have followed so far. Source: UPS.

In Littlefair's case, this past September he stopped selling and made a substantial buy of some 127,000 shares on the open market, putting $1.6 million of his own money on the table. However, shares have fallen 30% since, as Clean Energy Fuels' push to shift truckers away from diesel and to natural gas has not paid off as quickly as the market had hoped.

Ullman at J.C. Penney made a similarly large bet, only to see the share price continue to fall as losses build and sales slip. The company's latest update on earnings over the holiday shopping season showed a paltry 2% increase versus the year-ago quarter. This suggests there's little hope that the company can turn things around before it runs out of cash to operate. As colleague Adam Levine-Weinberg

J.C. Penney CEO Mike Ullman. Source: J.C. Penney.

points out, J.C. Penney's rate of cash burn and negative earnings indicate that the company has much less than a year before liquidity is a real problem. Chances are, vendors would stop delivering merchandise on credit long before that happened, further shortening the company's leash and leaving shareholders -- like Ullman -- at high risk of total losses.

Don't project and don't follow blindlyOwn your investing decisions; blindly following an insider into or out of any stock offers no advantages and no guarantees. Ullman and Littlefair both made seven-figure investments in their companies, and so far, both have turned out terribly in the interim. Facebook's share price has more than doubled from some of Sandberg's larger sales, but saying she should have waited is moot, because her reasons for selling have nothing to do with your reasons for buying.

A better approach? Find great companies with sustainable advantages and buy at a good price. If you start with great companies to invest in, it doesn't matter what insiders do.

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